One Way to Build a Position - Pyramiding
"You need to figure out how to make money being right only 20-30% of the time." – Bill Lipschutz
As most aspiring traders should know, each time we step up to the plate and take a swing, we should be looking to maximize our return (per unit of risk). In other words, we should always try to squeeze as much juice out of the market as logically possible. Only if our winners are larger than our losers, can we actually make headway.
Sometimes this is done simply by sitting still and letting the trade run along. But sometimes conditions are ripe for “pressing the trade” or, in other words, “pyramiding” into the trade.
After the recent UK Referendum turnout, which has seen the “Leave” voters take the upper hand, the Pound has been under pressure across the board. When you have a situation like this, you’ll want to “press the trade” and build a sizeable position – one single entry just doesn’t do the trick.
GBPNZD 1H Chart – Pepperstone MT4
Press the Trade, Not your Luck
Evidently, the way to maximize the return of a strong trending phase is to attempt multiple entries in the direction of the trend. However, having larger positions in the market increases not only your potential reward but also your risk. So we need to identify a way to press the trade, without pressing your luck.
Here are the ingredients to do this:
- only add additional positions when the stop loss on the initial position can be trailed, reducing risk on the initial entry;
- when the market moves slowly, and we haven't travelled far from the initial entry, a subsequent entry should be smaller. If we travel a good distance, the trailing stop will lock in more profit and the subsequent entry can be larger. Essentially, subsequent position sizes are dependent on the distance from entry to stop loss, and comparing this distance with the initial entry size;
- be sure to have a strong fundamental driver pushing prices along, because pressing trades arbitrarily, anywhere, anytime, is simply bad risk management.
GBPNZD 1H Chart – Pepperstone MT4
So let’s hypothesize an initial position entered on the Monday after the UK referendum, as price was breaking the Referendum-Day low.
Entry 1: 1.8850 // Stop Loss 1.9150 (300 pips). Now 300 pips seems like a wide stop loss, but we need to take into account market volatility. So we need to scale this to our account size.
With a $10,000 account, for example, if we want to risk 1% of our account on this initial trade, we need to fit 300 pips into 1% of 10,000 or $100. If we were to sell 1 mini-lot (10,000) of GBPNZD, each pip would be worth $0.73 and our total risk would be 0.73*300 = $219 which is just over double the amount we want to risk. So we need to cut that in half and trade 5 micro-lots or 5,000 GBPNZD.
The next two days, we cannot add any other positions unfortunately: price makes higher lows as the initial drop loses momentum. However, recall one of the ingredients of pyramiding: strong fundamental reasons.
On Thursday June 30th, Mark Carney (the Governor of the Bank of England) put another log on the fire by hinting at probable future weakness of the UK’s economy, and also hinting at potential interest rate cuts. Naturally, this is a very strong catalyst, and we can hypothesize another breakout entry, more or less at the same level.
Entry 2: 1.8800 // Stop Loss 1.9030 (230 pips). Normally, we would think that Pyramiding means adding another full position to our exposure. However, let’s explore a more conservative way of pyramiding, which leaves the “base” of the pyramid heavy, and still allows us to increase our size.
We do this by taking into account the total exposure in the market up to the current entry. So for Entry 2, there’s only the initial entry to consider. The risk outlay was 300 pips. So our new entry will have a size of (230/300)*1% = 0.77% which is 4 Micro-Lots.
We are then offered two more breakout entries lower down the ladder, with our trailing stop following nicely and locking in profit as price continues to buck the trend. Our hypothetical trailing stop is now resting at the high of Friday July 8th.
GBPNZD 1H Chart – Pepperstone MT4
Let’s explore another situation, starting from a higher time frame (the Daily), which is more useful for pure technical traders that avoid paying attention to the day to day sentiment shifts.
We always need to be moving strongly in a given direction to even consider starting the pyramid. So when price breaks strongly above a prior resistance, we can start to use the magnifying glass to start building our pyramid.
EURGBP Daily Chart – Pepperstone MT4
So now, once price is evidently in motion, we can simply wait until lower time-frame pullback cycles end, to get value entries into the larger move.
EURGBP 4H Chart – Pepperstone MT4
Just like in the GBPNZD trade, here too we are only adding when price is resuming its move upwards and the new stop is higher than the previous stop. We’re never adding when price is moving against us. That would be “throwing good money after bad money”.
Choose your Battles Wisely
As illustrated above, over the course of two weeks it is entirely possible to end up with a large concentration (>2% of total equity) in one single trade that you are trying to milk. The aforementioned method of adding exposure, taking into account total risk, will typically make for a “short” pyramid, which should not really rise over 2.5% of your equity. So you are exposed to additional upside, while keeping the downside at acceptable levels.
Just a few words of caution:
- look for strong drivers that influence market psychology: that’s when momentum and volatility will most likely be higher and allow you to actually pyramid into a move with relative ease; if you prefer to trade technically, you will most likely want to adopt a wider view of the market, and avoiding the day to day sentiment shifts.
- diversify: if all your eggs are in the pyramid basket, then your risk is concentrated. Instead, you should remember to diversify, and still take trades in other currencies that fit your setups. Your overall risk will remain at lower levels.
- stick to very strict risk limits: if you have 2.5% in one pyramid, 2.5% in another pyramid, and a few other trades on, your total portfolio heat might very well be around 10%! Of course that may be acceptable for some profiles but, generally speaking, that amount of risk is quite high. By all means, take the opportunities the market offers, but if you have capital locked up in a pyramid, it might be better to reduce the position sizes of other trades.
- be consistent with your position sizes: if your initial entry is 1 lot (100K) and your second entry is 5 lots (500K), then you are not building your pyramid correctly. The “base” isn’t the heavy part; your add-in is heavier than the base. What this means is that even a small reversal can undo all the previous good work.
But above all, start small and start slowly. Experiment with pyramiding at minimal sizes, as it can be psychologically challenging to combine these two elements, which each require practice:
- sitting on an existing trade, resisting the temptation to take profits early
- adding to the trade at “worse” levels, further along the price ladder. As traders, we all know that trends, at a certain point, end. So we don’t want to be pyramiding into an evident and extended trend that has been going on for a while. We want to be pyramiding into a fresh trend, limiting our trend risk.
NZDUSD Daily Chart – Pepperstone MT4
Over to You
Now you have the key elements to press a trade, without pressing your luck. USDCAD is close to a potential breakout…do you have what it takes to pyramid into this potential new upwards trend?
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